Monday, December 10, 2012

Jack Bogle wants to stop those naughty speculators

Jack Bogle, the founder of Vanguard, made some comments on CNBC today that warrant a discussion. He pointed out that the amount of new capital raised in the equity markets these days is about three quarters of a percent of the amount traded in the market during the same period.

CNBC: - "When you think about our financial system, the role of the financial system is to direct capital to its highest and best and most profitable uses," Bogle said.

While companies raise about $250 billion a year in equity financing through IPOs and additional equity offerings, Bogle said there's $33 trillion worth of trading going on, "which is basically betting on the psychology of the markets. It makes no sense."

He thinks it's a problem because people trade on sentiment rather than long-term investing, creating issues for the market and the economy. He is also saying that it hurts long-term investors. Here are some thoughts on the topic:

1. The discussion initially was focused on high frequency trading. The real issue with that part of the market has more to do with quote spamming (which has been increasing) rather than the trading volumes.

2. High trading volume helps long-term investors by creating tremendous liquidity and reducing transaction costs. To buy or sell a stock costs a fraction of what it used to 10-20 years ago because of improved market liquidity and trading volumes. Transactions are also far more efficient in terms of execution than anything we've had in the 90s for example. And a long-term investor can have comfort that when it's time to sell a stock, she will be able to do it with ease (making her more likely to buy the stock in the first place).

3. Taking away liquidity, which is what would happen if trading volumes went down to several hundred billion per year, would turn the market into something akin to private equity. If Mr. Bogle thinks Wall Street is getting rich charging investors for stock trades, he hasn't seen the fees charged by private equity firms. And those who invest in private companies know you can't "rebalance" that portfolio.

4. The whole reason many firms can raise money in the US public equity market is its high liquidity. If liquidity is taken away, the $250 billion a year in IPOs and secondary offerings would decline to a fraction of current levels - a severe shock to economic growth. Imagine buying FB at the IPO and being forced to hold it for years (which would be Mr. Bogle's preference).

5. The fact that many investors trade in and out of stocks, even though most can't beat the overall market in the long run, should not concern Mr. Bogle. These traders (or what he calls speculators) are liquidity providers, and any healthy market absolutely needs them (whether it's stocks, futures, bonds, or FX).

Jack Bogle of course has a set of solutions to the problem of market "speculation".

CNBC: - He proposes three ways to limit market speculation — a transaction tax, a tax on very short-term capital gains and federal rules to make certain money managers are looking out for their clients' best interest.

Let's go through each of these:

1. Transaction tax will lower liquidity and end up hurting the small investor. As the French found out (see post), institutional investors often find a way to get around the tax (particularly if the regulation is poorly designed).

2. Tax on very short-term cap gains - and Jack Bogle wants it also to be charged to tax-exempt accounts - is simply a tax on people's 401Ks. That's because the bulk of 401K accounts hold some actively managed mutual funds. It's not enough for people to pay high fees on their retirement accounts (as mutual funds and the 401K providers both charge fees). Now they would have to pay taxes as well? Of course Mr. Bogle would prefer that everyone moves their money to Vanguard's index funds (which is not a bad strategy, but it's not for everyone and you can't force it on people). Another problem with this sort of tax is that investors would be encouraged to sell stocks that drop quickly (in order to offset their "very short-term cap gains" with "very short-term cap losses"). That would potentially precipitate sharp selloffs.

3. It's not clear what exactly he means by having "certain money managers looking out for their clients' best interest". Different clients have different needs and applying the Vanguard model is not for everyone.

Dictating (via legislation) to investors what they can and can't do is poor policy and goes against the concept of free markets. The whole idea of "punishing" this or that behavior with taxes and fees (in the name of fighting "speculation") is not productive.

Ironically, tax breaks for long-term holders is probably the best policy to encourage more long-term investing. Yet this policy is expected to be weakened shortly, as long-term cap gains tax is likely to be increased next year.